Adjustments to the accountability and transparency of the European Central Bank

Sylvester Eijffinger24 October 2009

Governments are restructuring their financial supervision systems. This column warns that the proposed new structure for European financial supervision is poorly coordinated and will not help in a systemic crisis. It discusses how the ECB might coordinate macro-prudential supervision in the euro area.

It is widely agreed that central banking should not be subject to "political business cycles". Consequently, in the last decades, it has become an integral part of modern central banking policy that full operational (or functional) independence of central banks is a welfare-enhancing quality. However, the objectives of the central bank should then be clearly defined from the outset, the bank should be accountable for its actions, and the public should have a solid trust in its actions. The ongoing crisis may well have made central banking more complicated. For example, with the European Central Bank (ECB) probably about to gain more powers in financial supervision, ECB objectives may in the future no longer be as clear and monothematic as under the pre-crisis conditions of "simply and only price stability".

Will the present setting of accountability still be sufficient? Recently in March 2009, the European Parliament (EP) commissioned a study on "Accountability and Transparency in Central Banking" written by Paul de Grauwe and Daniel Gros, who propose, inter alia, changes to the accountability of the ECB and its relation with the EP. I will address this issue by discussing financial supervision in the US, the UK, the euro area, and the EU. I then evaluate the new structure of European financial supervision and suggest adjustments to the accountability and transparency of the ECB in that respect.

The US government now envisages another role for the Federal Reserve System (Fed). To protect financial stability, the Fed will primarily focus on macro-prudential supervision of financial institutions, while detailed supervision of individual institutions (micro-prudential supervision) will be assigned to a new authority. Kremers and Schoenmaker (2008) prefer this system (the so-called “twin peaks” model) not only at the national level but also at the European level. They support their position by referring to the coordination problems between the British Financial Services Authority and the Bank of England after the collapse of Northern Rock. However, the British Finance Minister recently announced that the Bank of England will be given again more power to avert financial instability.

Given that the US plans for the restructuring of financial supervision still need to be worked out further, it is hard to judge them. However, a potential weakness is the possible conflict between the traditional and new tasks of the Fed. In the case of a bank failure, the Fed might feel pressured to provide liquidity, while from the perspective of monetary stability this might be undesirable – financial sector supervision may have spillover effects (externalities) onto monetary policy. In fact, when the Fed is both supervisor and has the means to act as a lender of last resort, banks may be tempted into taking on additional risks (moral hazard). They will reap full benefits if things go well, while in the case of failure losses will be limited due to intervention by the Fed – exactly what happened in the emergence of the current crisis.

Additionally, in a crisis, the central bank must be able to immediately judge the amount of liquidity to be supplied to the banking sector. This may be difficult when there are separate supervisory authorities; one might thus consider an obligation to provide the Fed with the necessary information about the liquidity of individual institutions.

Financial supervision in the EU

Europe can draw a number of useful lessons from the current crisis. At the moment, responsibility for financial supervision is at the national level in Europe; this is shown in Table 1. Clearly this patchwork of supervision will become more and more difficult to maintain due to the ongoing economic and financial integration of Europe. It would be a missed opportunity to not exploit the current crisis to move towards uniform financial supervision in Europe under a single authority.

Table 1. The role of central banks in the EU in promoting financial stability

Source: Eijffinger (2007), based on update of Goodhart and Schoenmaker (1995).

Currently, supervisory coordination is based on a framework that has been largely harmonised via EU law and that is supported by the Level-3 Committees of the Lamfalussy framework for regulation and supervision. It consists of three layers: (1) crisis prevention, (2) crisis management and (3) crisis resolution, described in Table 2.

A number of developments, in particular ongoing financial integration and the growing number of banks with cross-border activities, have led to initiatives to strengthen this framework. The Lamfalussy framework was installed in 2001 for the purpose of regulating the asset markets and extended in 2004 to include the insurance and banking sectors. In 2007, enforcement of the Level-3 Committees of supervisors on three accounts was agreed upon in terms of legal basis, accountability, and decision-making.

Additionally, a new Memorandum of Understanding is in the pipeline as part of the strategic framework on financial supervision of the ECOFIN. This Memorandum of Understanding contains a set of common principles for cross-border crisis management, a recently developed common analytical model of a crisis, and a number of practical guidelines for crisis management.

Table 2. The EU framework for safeguarding financial stability

Source: ECB (2008, Table 1)

The new structure of European financial supervision: Will it really work?

Almost three months ago the European Heads of State and Government agreed on a new supervisory structure for the European financial sector. This structure is mainly based on the recommendations of the High-level Working Group chaired by Jacques de Larosière. That committee excessively accommodated the desires of Germany and the UK, who oppose transferring responsibilities to a central European body. The recommendations have not gone far enough; there will be no central EU financial supervision authority. Instead, national supervisors now coordinate their micro-prudential supervisory activities internationally through the three Level-3 committees of the Lamfalussy-framework: CEBS (Committee of European Banking Supervisors), CEIOPS (Committee of European Insurance and Occupational Pensions Supervisors) and CESR (Committee of European Securities Regulators). However, these colleges of supervisors do not have the financial instruments to act in bad times, and it is not at all clear who will be in charge of them.

Fortunately, the European solution for macro-prudential supervision is a lot better. The so-called European Systemic Risk Board (ESRB) will guard financial stability in Europe and should warn European banks and insurers when they are taking too many systemic risks. Since the ESRB is connected to the ECB (the Board consists of the central bank governors of all EU member states), it is indirectly able to make use of the liquidity provision instrument.

However, an important question is how the ESRB’s macro-prudential supervision will coordinate with micro-prudential supervision. Moreover, the burden-sharing problem – how to divide the bill of a bank failure between the countries in which it operated – remains unsolved. Absent a solution to this problem, it is impossible to set up solid European supervision.

Will the new European supervisory structure really work? I am afraid that this structure will not help in a systemic crisis, as we have seen recently. Sadly, Europe has not learned enough from this crisis.

Adjustments to the accountability and transparency of the European Central Bank

The new structure of European financial supervision will require, of course, adjustments to the accountability and transparency of the ECB within the framework of the Monetary Dialogue with the Committee on Economic and Monetary Affairs of the European Parliament. De Grauwe and Gros (2009) propose that the ECB formally and practically differentiate in its policy and objectives between normal and crisis times, and they also propose some changes to the accountability and transparency of the ECB and its relation with the European Parliament. In practice, it is very hard to distinguish between normal and crisis times and I would therefore advise the Committee on Economic and Monetary Affairs to establish a Financial Dialogue with the President of the ESRB/ECB for discussing macro-prudential supervision in the euro area and the EU on a bi-annual basis after the publication of the Financial Stability Review by the ECB.2 Article 105(6) of the Treaty explicitly mentions the possibility for the Member States to decide to confer upon the ECB specific tasks in the domain of financial supervision. In conjunction with this a Financial Dialogue could be established with the Chairs of CEBS, CEIOPS and CESR to discuss micro-prudential supervision in the EU on a bi-annual basis. Preferably, the Financial Dialogue should take place in June and December after the bi-annual publication of the Financial Stability Review.

Footnotes

1 This section and the next are mainly based on Beetsma and Eijffinger (2009). An extended version of this column has been published as a Briefing Paper in September 2009 for the Committee on Economic and Monetary Affairs of the European Parliament.

2 The issue of the Financial Stability Review of June 2009 describes the main endogenous and exogenous trends and events that characterised the operating environment of the euro area financial system over the period from 28 November 2008 until 29 May 2009. The Financial Stability Review is bi-annually published by the ECB.